A Rare Glimpse Into The Fed's Discount Window Courtesy Of The Brewing Lehman-Barclays Scandal
For those interested in the implications of our observations of the Barclays-Lehman transaction as they pertain to the Federal Reserve's discount window, we recommend skipping to Part 2.
Part 1: The Lehman "Blue Light Special"
It is becoming increasingly likely that Barclays will have to pay a cool $5 billion (at least) in additional consideration to the Lehman estate, after the Official Committee of Unsecured Creditors came out yesterday with a hefty joinder piece to the debtor's motion that Barclays materially misrepresented and, in essence, stole $5 billion or more from under the noses of both Lehman Brothers Holdings and its Creditors, all as the megalomaniacal Judge Peck was trying to ram the largest prearranged stalking horse bankruptcy through, in the shortest (im)possible amount of time, just so he could print "Judge Peck - Greatest Restructuring Judge in the World" t-shirts at the Bowling Green sweat shop just off NY Southern Bankruptcy court. As it often happens, the exposure of this alleged fraud was just a matter of time, and it would appear that Bob Diamond who was counting on a meek opposing creditor committee, and complicit debtor (which he got for a good 12 months, courtesy of a toothless Official Creditor Committee ) is about to pay through the nose for what he thought at the time was the greatest rip off since Bear Stearns.
A filing by the OCC provides a very good summary of the five purported axes of scammery that the Barclays' pickpockets were hoping to effectuate under the "End is Nigh" guise of systemic collapse, and the need for a quick transaction closing, no matter what the cost to Lehman:
- Implied $5 Billion Discount. Unbeknownst to the Court or the Committee, early in the negotiations, Barclays and the Lehman Sellers agreed to give Barclays a $5 billion discount from the transferred assets' book value. Indeed, evidence suggests the $70 billion figure contained in the Asset Purchase Agreement ("APA") was not the value on the Lehman Sellers' books at all. Instead, it was a "negotiated" number with an embedded $5 billion discount. This discount was not disclosed in any of the transaction documents given to the Court.
- Significant Structural Changes To Sale Transaction. The APA contemplated Barclays would acquire the North American broker dealer operations by purchasing certain of its assets and the liabilities relating to those assets. However, on September 17, 2008, the Federal Reserve Bank of New York (the "Fed") insisted that Barclays assume the Fed's obligations to provide financing to LBI. The Fed had financed LBI through a repurchase agreement (the "Fed Repurchase Agreement"). Barclays agreed to step into the Fed's position and entered into its own repurchase agreement with LBI (the "Barclays-LBI Repurchase Agreement"), which replaced the Fed Repurchase Agreement. As is common in financings of this type, the Fed Repurchase Agreement contained an approximately $4.4 to $5 billion cushion or haircut in valuing the assets in relation to the liabilities. Barclays agreed to provide $45.0 billion in funding, which LBI would secure with assets worth at least $50 billion. After executing and filing the APA, the parties ultimately decided to transform the Barclays-LBI Repurchase Agreement into an asset sale, with Barclays keeping all of the collateral pledged under the Fed Repurchase Agreement (the "Fed Portfolio") — which contained not less than $5 billion additional collateral beyond the $45.0 billion that Barclays was required to advance, i.e., the haircut.
- Mad Dash For Unencumbered Assets. Not satisfied with the $5 billion cushion, beginning on Friday September 19, 2008, Barclays demanded that the Lehman Sellers transfer billions of dollars more additional assets. The search for these assets continued after the Sale Hearing, and included (a) no less than $1.9 billion of unencumbered securities in the "non-actionable" box, (b) 15c3 Securities valued at between $750 million and $800 million and (c) an undisclosed amount of collateral supporting the OCC Accounts and other exchange-traded accounts (valued at approximately 2.3 billion).
- Overstated Liabilities. The evidence also reveals that Lehman and Barclays intentionally overstated the Cure and Compensation Liabilities to foster the impression that Barclays was assuming greater liabilities. The APA Scheduled these amounts at $2.25 billion and $2.0 billion respectively. In reality, the estimates of the liabilities were only approximately $1.3-$1.7 billion.
- Conflicts Of Interest In Negotiations. The Lehman Sellers' teams negotiating on behalf of the estates were steeped in personal conflicts of interest. Several of the negotiators for the Lehman Sellers either negotiated their employment agreements in the midst of the Sale Transaction negotiations or at least knew that they would be transferred to Barclays.
While we have discussed the first four issues previously on Zero Hedge, the last point deserves additional mention as it points to what could be potentially criminal superposition of personal over fiduciary interests by a select few "negotiators" on both the Lehman and Barclays side. From the filing:
Deposition testimony revealed the identity of a certain core group of individuals responsible for negotiating the Sale Transaction. On the Lehman Sellers' side, the negotiators included Bart McDade (President), Skip McGee (Managing Director - Head of Investment Banking), Mark Shafir (Co-Head of M&A), Alex Kirk (Advisor), Mark Shapiro (Head of Restructuring) and Dick Fuld (CEO). Steven Berkenfeld (Managing Director, Legal) executed the APA, the First Amendment and the Clarification Letter on the Lehman Sellers' behalf. Also involved from the Lehman Sellers were Paolo Tonucci (Treasurer), Ian Lowitt (CFO), Mike Gelband (Head of Capital Markets), Eric Felder (Co-Head of Fixed Income) and Martin Kelly (Global Financial Controller). At the operations level, the Lehman Sellers' employees involved included James Hraska, Robert Azerad, and Alastair Blackwell. As explained below, many of these individuals became Barclays' employees following the Sale Transaction.
On the Barclays' side, the chief negotiators appear to have been Rich Ricci (Chief Operating Officer), Archie Cox (Chief Executive Officer - Americas), Michael Klein (Advisor), Gerard LaRocca (Chief Accounting Officer - Americas), Bob Diamond (Chief Executive Officer), and Jerry del Missier (President). Also involved were Patrick Clackson and Michael Keegan. David Petrie and John Rodefeld were involved at the operations level on the Barclays' side.
And this is the part that we recommend regulatory and legal enforcement officials focus on the most:
Many of the individuals negotiating the Sale Transaction on the Lehman Sellers' behalf became Barclays' employees following the closing. Indeed, McDade told Lowitt that Barclays deemed eight individuals, including Lowitt himself, as critical to the transaction. The other seven were Skip McGee, Ajay Nagpal, Tom Humphrey, Eric Felder, Gerald Donini, Mike Gelband and Hyung Lee. The transfer of these eight individuals to Barclays apparently became a condition of the Sale Transaction closing -- a fact disclosed during the Sale Hearing. McDade also worked for Barclays after the sale transaction. However, the significant bonuses paid to these employees after the Sale Transaction closed was not disclosed to the Court. As Alex Kirk explained, "[s]everal of my colleagues. . . who had signed employment agreements were resigning from [Barclays] and receiving large payouts upon their leaving the firm." Kirk, who McDade had re-hired to assist during the negotiations, also went to work with Barclays after the transaction. Because he had no written employment agreement with Barclays, he prevailed upon McDade to press Barclays for a bonus package because "[McDade] was on point for those sorts of issues with Barclays." [Blacked out text, presumably discussing bonus and compensation in detail]. Shapiro, Azerad, Blackwell, Hraska, and Kelly each joined Barclays as well.
The fact that both sides of the negotiating table were incentivized to produce the lowest possible transaction value for the Lehman Brokerage Sale to Barclays is certainly not representative of a fair arms-length negotiation: it demands a close scrutiny of each person's personal motivations and how these could have been misaligned with the interests of equity and bondholders of Lehman, whose interests Messrs McDade, McGee, Kirk, Shapiro, Azerad, Blackwell, Hraska, and Kelly have a much greater responsibility to, than to their own personal wallets. And if this means Lehman creditors pocket the difference of not only the $5 billion that may have been misappropriated by the Barclays-Lehman crack team, but also obtain a clawback of any improperly structured bonuses paid out to Lehman employees (if we need a Pay Czar, this is "non-earmuff" time) who were set on screwing over Lehman creditors at any and all cost, so be it.
Part 2: In which the Federal Reserve accepts 5,136 shares of bankrupt retailer Shaper Image as collateral (among others)
As part of the escalating fight between the Lehman estate and Barclays, one of the tangential benefits is a quick glimpse into what goes on at the Fed's discount window. As a result of the unsealing of tomes of data, information scourers will have a field day by going through the thousands of pages made public for the first time, that disclose not only Lehman's asset exposure, but also the amount of collateral proffered to Lehman by the NY Fed, by JPMorgan as primary custodian in a tri-party repo involving the Fed, and subsequently how this collateral was viewed by Barclays, as well as the measures it took to do all it can do minimize the amount of money it would have to pay to assume the collateral (which was declining in value every day).
In the week following the Lehman collapse, Barclays, as part of its Asset Purchase Agreement, was supposed to purchase (at first) $70 billion worth of assets (coupled with assuming the related $69 billion of debt): an amount which for liquidity-depleted Lehman was financing with overnight loans from both the NY Fed and from JPMorgan, which acting as a Fed agent, was involved in a tri-party repo transaction with Lehman Brothers. Yet Barclays did all it could to minimize the amount of cash it would have to pay JPM, as it suddenly realized the assets it had purchased were quickly dropping in value. A good summary is presented in the UCC filing:
On Friday night, for the first time as far as we know, the Bankruptcy Court was apprised of a different 'deal' between Barclays Capital and Lehman Brothers -- and that Barclays Capital was no longer purchasing $70 billion in assets and assuming $69 billion in related debt. But the Court was not apprised of the purchase that Barclays Capital now says it agreed to make. Instead, of the Court being told that Barclays Capital was purchasing approximately $49.7 billion in securities for $45 billion in cash, the Court was told that Barclays Capital was purchasing $47.4 billion in securities for $45.5 billion in cash. In addition, the Court was told that the reason for the change was a deterioration in market prices, an explanation that we now know to be incorrect .... [I]nasmuch as you ended up taking securities that had not been part of the 'Fed collateral' -- again, some were part of the 'Barclays Capital tri-party collateral' and still others were not financed by JPMorgan at all -- we believe that a full accounting should be done. It is altogether possible that the LBI estate and its creditors gave you more or less value than you were entitled to receive. Moreover, the Bankruptcy Court was told that Barclays Capital was to receive $47.4 billion (not $49.7 billion) in securities and to pay $45.5 billion (not $45 or $45.2 billion) in cash. We are both duty-bound to ensure that LBI received the value it was supposed to receive in exchange for your $45 billion. We have offered several times to do this accounting with you (and, as appropriate, the Fed), and it is ntirely possible that the SIPA Trustee and the Bankruptcy Court would want such an accounting, but your personnel have declined, citing the amount of time and effort it would take. We should do this accounting and should do it now...
A different way to explain what was happening is provided by the transcript of Kirk's confidential deposition in court, also made public:
. . . [A]s I understood it from the way that Mike Keegan explained it to me was that the Fed had been providing a repo for Lehman Brothers earlier in the week of approximately $50 billion, that the Fed had made it known that they wanted to be repaid on that repo, and that Barclays had agreed to assume that repo obligation from the Fed. Without that financing the firm would have collapsed the next morning. So the way it was explained to me was, during the transfer of those -- that loan and the collateral associated with that loan, there were many pieces of collateral that Barclays could not value, so they did not accept them in transfer from the Fed. And mechanically, it was explained to me the way that worked was, in a tri-party repo, the Fed transferred all of the positions to JPMorgan and then JPMorgan began transferring those positions upon the receipt of money from Barclays transferred money, and then they would transfer the positions that secured that repo. And at some point during that process, Barclays became very uncertain as to some percentage of that collateral, I don't recall the exact amount, but it was a large number, maybe as much as, you know, 20 percent of the collateral, and when Barclays didn't accept those positions, they, by definition, just got left at JPMorgan. They -- so JPMorgan was left with collateral that they were not comfortable with but Barclays would not accept, so -- and JPMorgan, I guess they attempted to negotiate but couldn't get that negotiation done.").
Barclays' attempt to nickel and dime JPM (and the US taxpayers) so infuriated Jamie Dimon that he penned an angry letter to John Varley, Barclays Group CEO (which CC:ed Barclays' president Bob Diamond), threatening with litigation in case Barclays is intent on sticking JPM with Lehman collateral that it thought was without value and not worth assuming in a time when every single day stock prices were crashing further lower.
A very telling excerpt from the note is the following description of what was happening the Thursday evening after Lehman had filed:
Chaos reigned throughout Thursday evening. You sent another $40 billion in cash. Billions of dollars of securities were sent out and many were "DK'd" or otherwise sent back. By about 11 o'clock, when DTC shut down, you had apparently received a net total of approximately $42.7 billion of securities. All of the confusion was heightened by the absence of any definitive list of securities you were purchasing - an absence that we believe further supports the notion that you were taking all of the securities collateralizing our intraday advances.
Basically, Barclays tried to rip JPMorgan off by collecting not just on the Lehman collateral which was part of the Barclays APA, but pretty much all the collateral in the tri-party repo, backed and funded by the NY Fed and JPMorgan. But the bottom line is that chaos ruled: tens of billions of dollars were flying on the wires at any given minute, in order to give the impression that with Lehman's collateral now on Barclays' books everything was magically better.
In this firestorm of wire transfers, the Fed's direct Lehman exposure was made obvious. From the Jamie Dimon letter, one can see that in the days after Lehman's bankruptcy, over $50 billion in securities had been assumed by the Fed via FRB and DTCC programs, which also included anywhere between $3 billion and $4.5 billion in equities. It was Barclays' onus to shift this entire collateral exposure to its own balance sheet (while paying both the Fed and JPM off).
Another way of representing this activity immediate to the $40 billion transfer highlighted by Dimon above, comes from the following table, showing the insane activity on the wires between the Fed, the Tri-Party repo, and other parties. Indicative of just how precarious the system was, is the over $6.2 billion in DK'd transactions (a staggering amount), which meant that the fate of the successful closure of the Lehman deal (and the September 19th near collapse of the Reserve money market fund) constantly hung on by a thread.
An amusing tidbit highlighting the manner in which Barclays was attempting to game the system, is that even as it was unwilling to assume much of the collateral that the Fed had accepted earlier (as we pointed out, this includes equities, which as Karl Denninger reminds us, is allowed by Section 13.3 under "unusual and exigent circumstances"), and which is the main focal points of JPM's complaint to Barclays, what it did accept it promptly proceeded to mark up aggressively: none other than Jamie Dimon points out that very fact:
Indeed, much of the collateral financed by Barclays Capital on Wednesday night was the very collateral financed by the Fed on Monday and Tuesday nights. (For a very significant amount of that collateral, the movement of which between the Fed collateral pool and the Barclays Capital collateral pool was undoubtedly deliberate, Barclays Capital assigned a loan value greater than the amount that had been assigned by the Fed.)
The games banks play, highlighted by the very master of the game.
Another representation of what was happening to the collateral pool in the very critical Tri-Party agreement is the following table highlighting the variance between Lehman's haircuts on various assets (a nominal 4% weighted average) and that demanded by the Federal Reserve (9% weighted average). What is shocking is the eagerness by the Fed to lend against equities after a mere 20% haircut in principal value. This begs the question, just how much of the collateral pool in the Fed's discount window is even covered at all, assuming extensive loans from the time of Lehman's collapse are likely significantly underwater not only in terms of equity collateral, but for non-IG corporates, converts, and private labels, all of which had the same blanket haircut. The chart below shows that on the Friday before Lehman's collapse, the Fed was willing to accept virtually any toxic asset into its own balance sheet, after applying a generic 20% discount.
And if you have ever wondered just how a hundred billion dollar + organization has a valuation set (almost) literally on a napkin, here are the handwritten notes by Lehman's global financial controller Martin Kelly:
Yet what readers will likely have the most interest in is the following CUSIP by CUSIP representation of all the securities (equity and otherwise) that the Fed was responsible for as part of the Tri-party Repo Agreement, thereby pledging the goodwill of taxpayers' returns on such equities as bankrupt WHX, Tower Automotive, Federal Mogul, Intermet, Finlay Jewelers, and many other quality names. The full file can be found here. Below is a sample of the representative equities that the Fed was backstopping for Lehman in the days when it seemed like the entire financial system would collapse:
Coming full circle, the major question we have is what, if any, considerations did the Fed use when determining how much of Lehman's collateral pool it would be willing to onboard in the discount window. And if back then it was willing to accept securities of bankrupt companies as value pledges to US taxpayers, why would one assume that anything has changed? The next time there is a "risk-flaring" event (and with bankrupt companies presumably still on the Fed's balance sheet, it is merely a matter of time), how much more leeway will be given to toxic assets? Will the Fed now allow for a 10% haircut instead of 20%? Or how about 5%? Or maybe it will actually say the securities deserve a premium, since all that money Bernanke is printing has to go somewhere. We hope that the over 300 members of Congress who already support Ron Paul's "Audit the Fed" Initiative consider the implications of what the Lehman fiasco has taught us, and how this unique look into the Fed's balance sheet should be a very critical reminder of just how much risk the Fed is willing to take on with taxpayer capital when bailing out a financial system that, absent ongoing accounting gimmickry and endless Reserve Banking System subsidies, is still rotten to its core.